Borrowers' Fate Rests On Refi Options

During the booming real estate market of the previous five years, creative financing dominated the landscape. Investors were demanding high leverage in deals, and this produced a bumper crop of short-term financing options. Mezzanine, bridge and other short-term equity financing alternatives ruled the marketplace.

But as the current market cycle retreats from its peak and Wall Street continues to fall out of the race to fund high-leverage deals, a potential squeeze looms large for owners and their investors in need of refinancing. And the maturity of this bumper crop of short-term debt is due to hit sometime during the next 12-24 months.

The Federal Deposit Insurance Corp. recently reported that of the $839 billion in outstanding commercial real estate loans among federally insured banks as of Sept. 30, 2007, a whopping $547 billion represents short-term construction and land development loans.

Bear in mind that these figures do not include the massive number of deals financed by lenders in the capital markets. Analysts are concerned about the sustainability of some high-leverage and transitioning deals in the face of falling property values. Investors who must find alternative financing in a shrinking playing field are under pressure.

Equity partners on the hook

In early December, Simon Property Group announced that it would record a non-cash impairment charge during the quarter to write off the entire value of its equity investment in a joint venture with Toll Brothers Inc. The venture was created to develop a planned community of residential units in northwest Phoenix.

The roughly $26 million write-off by the nation's largest shopping center REIT coincided with a $314.9 million write-down by Toll Brothers, including $56 million of the joint venture's value. Simon quickly pointed out on Dec. 7 that after recording the impairment charge, the company would have “no additional funding obligations” to the joint venture.

While this announcement may not prove to be a significant blow to Simon Property stakeholders — reducing available funds from operations and income available to shareholders in the quarter to $2.02 per share from $2.13 — it is a significant development for the industry itself. The reason? This move by a major property investor suggests that falling property values and the inability of investors to find new short-term debt and equity partners is proving to be a lethal combination.

Refinance risk looms

In a recent conference call to discuss their outlook for the structured finance marketplace, analysts at Fitch Ratings indicated that they are closely monitoring CMBS and CDO transactions with a high concentration of loans that are scheduled to refinance in the near future into a potentially illiquid market.

Susan Merrick, Fitch's managing director in the structured finance group, indicated the agency analyzed 124 such transactions totaling $91 billion. And while potential bond defaults were within “normal expectations,” according to Merrick, refinance risk remained the agency's single greatest concern.

“Refinance risk is a greater concern with loans that were transitional and originated as shorter-term, floating-rate or five-year, fixed-rate loans,” Merrick says. These properties generally were in a state of transition at the time the loans were made. In some cases, the short-term capital was used to reposition assets and improve cash flows.

“Fitch is now concerned about the potential for these properties to improve in cash flow before entering into long-term fixed-rate financing,” says Merrick.

If the business plan created to achieve property cash flow improvements is not realized — as was the case with Simon Properties and Toll Brothers — additional credit or investment will have to come from players such as B-note buyers, real estate opportunity funds and real estate-focused hedge funds.

So how will lenders holding short-term debt tied to properties that are valued lower than originally anticipated fare in today's marketplace? The answer, of course, depends on a lender's access to two major components of real estate investing today — long-term capital and asset management expertise.

Real estate-related opportunity funds will do well to load up on talented asset managers. Over the next year, they will need the expertise to handle the slew of short-term debt that many borrowers are struggling to refinance and convert into long-term permanent financing.